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How the midterm elections could impact markets

This week’s mid-terms elections are being billed as a referendum on President Trump. Is the result likely to affect equities?

byGarry White

in Features

05.11.2018

Some say that, like oil and water, business and politics do not mix. Politics tends to be an emotional affair and business owners need to use rationality to make the best decisions. But, in reality, business and politics are inextricably linked. Donald Trump’s trade war and Iranian oil sanctions, the Italian budget dispute and the Brexit outcome are all weighing on the minds of global investors and impacting decisions at some of the world’s largest companies. Tuesday’s US mid-term elections have come at a time of significant market nervousness, with many investors concerned that we are nearing the end of the cycle. Could the outcome have a major impact on markets?

The market expects the Democrats will win the House and Republicans will retain the Senate. This is likely already priced in. Democrats need to win 23 more seats to win a majority – and House minority leader Nancy Pelosi is confident the party will win 30 seats and flip the chamber. The situation appears better for Republicans in the Senate, as Democrats are defending 26 of the 35 seats on the ballot. However, the last few years has taught us that, when it comes to politics, market consensus can be utterly wrong. The election of Donald Trump, the win for the “leave” campaign in the Brexit referendum and Theresa May’s disastrous election result last year have all demonstrated that markets can find politics difficult to deal with.

Even when the market finally realises which direction the wind is blowing, investors can charge off in the wrong direction. For example, S&P futures slumped by about 5% – the maximum allowed amount – as it became clear that Donald Trump would defeat Hillary Clinton in the US election two years ago. However, hindsight now tells us that this reaction was wrong. The Trump administration was elected on a platform that would unleash a wave of stimulatory measures, including deregulation and tax cuts, that turbo-charged the bull market and sent Wall Street indices to a series of new all-time highs. Even with recent market falls, the S&P 500 Index has gained about a quarter since Trump’s election to the Oval Office. A similar dislocated reaction was seen in the aftermath of the Brexit vote, when a major mark down of UK-listed assets was reversed within a few days as the fall in sterling looked set to boost foreign earnings on translation into pounds.

History shows us that the incumbent president’s party rarely makes gains in the midterms. The main exception to this case was George W Bush, who managed to pick up seats in both the Senate and the House as the election came in the wake of the 9/11 terror attacks. However, history also shows us that midterm elections are less of a “market event” than presidential elections, with results only driving modest market moves. Indeed, Alec Phillips, Goldman Sach's chief political economist, notes that over the last 60 years, the S&P 500 has risen by 0.7% on average from the day before to the day after midterm elections. Even when the incumbent’s party suffered big losses or control of Congress shifted, the market reaction has been slight.

A divided Congress is likely to mean the current administration’s legislative agenda will stall as it won’t have the votes to pass bills through the House. Indeed, in the 2010 election, Republicans gained the House and effectively brought an end to Barack Obama’s legislative accomplishments, despite the fact he served six more years. The next Congress will need to vote through President Trump’s changes to the new Nafta deal with Mexico and Canada, and they could try and seek changes to the bill. However, the biggest concern for markets should the president become legislatively impotent relates to the trade war. He will still be able to pursue his foreign policy and he could use his executive powers to ratchet-up trade tensions with China. Much of this is likely to be rhetorical, however, and his meeting with Chinese leader Xi Jinping at a summit later in November is far more significant than Tuesday’s elections on this front.

One sector that has a big stake in this election is healthcare, as the US struggles to find a system that works. Indeed, the healthcare industry has given $46.7m to candidates so far this year, according to the US Center for Responsive Politics. Of the money given by healthcare political action committees, (PACs) 57% was given to Republicans. Therefore the sector could be extremely volatile next week, with support for action on drug pricing appearing to be a non-partisan issue that is likely whatever happens. However, disagreements on details are likely – and the same goes for President Trump’s apparently forgotten pledge to spend more than $1 trillion on infrastructure.

Investors should not rule out the possibility of a “Trump triumph” either, where Republicans maintain control of both chambers. This will allow the president to carry on with his legislative programme, but there are concerns in some quarters that this could embolden his criticism of the Federal Reserve. President Trump said that Jay Powell, the central bank’s chair, had “gone crazy” because of the expected pace of interest rate rises next year. This may push the Fed to stay firmly on its hiking path to preserve its appearance of independence and increase the risk of policy error. Whatever happens on Tuesday, November looks set to be a volatile month until the result of the meeting between Presidents Trump and Xi is known.

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